The payment of dividends is viewed by many as a sign of financial strength. What is little discussed is the ways in which a sensible idea can be distorted by behavioral heuristics. In this article I shall evaluate dividends from the perspective of heuristics as the term is used by Gerd Gigerenzer, on the one hand, and Daniel Kahneman, on the other.
Gigerenzer uses the term to describe a useful shorthand in situations where full knowledge is simply unavailable in a pinch. Think of the outfielder fielding a fly ball. He has no time to measure things like air density, wind direction, speed and angle of the ball, and run complex computations. He has learned that by simply running in a direction that maintains a constant angle to the path of the ball he and the ball will soon meet. (A sailor or driver, eager to avoid a collision, does just the opposite.) A heuristic that focuses on dividend-paying companies is useful in that it narrows greatly the number of companies to review. An even narrower heuristic would be to look only at companies with a long record of growing their dividend. Such heuristics are useful. We don’t have enough time in a day to do everything, so finding a simple rule to catch the ball is necessary. (I fear that modern finance—particularly as interpreted by the marketers—has pushed us in the opposite direction, misleading us to believe that we are improperly invested, unless we are exposed to all manner of asset classes, which we know little about—but a marketer is eager to sell us.)
But a Gigerenzer heuristic is just that: a rule of thumb that enables us to get a job done. Quick and dirty, he calls it. But useful heuristics, like good ideas, get us into trouble when they are pushed too far and are treated as dogma. (As children we learned, “If you don’t at first succeed try, try again.” By the time we are adults, however, we have learned when quitting is prudent.) The crisis of 2008 should have shown us how both companies and investors can get themselves into a bind when they start to think of the dividend as sacrosanct. The focus becomes the sacrosanctity of the dividend and not the long-term, total compounding of the business, which ought to be our primary interest and responsibility, as shareholders.
Some of this sacrosanctity has its roots in the kind of heuristics that Kahneman has studied. His research earned him, as a psychologist (!), the Nobel Prize in economics. He focuses on non-expert, intuitive perceptions, which, on closer scrutiny, are revealed as non-rational, or behavioral. In his latest book Thinking, Fast and Slow [For an excellent review read Freeman Dyson’s review in the New York Review of Books.] Kahneman gives the following example: “Many years ago I visited the chief investment officer of a large financial firm, who told me that he had just invested some tens of millions of dollars in the stock of Ford Motor Company. When I asked how he had made that decision, he replied that he had recently attended an automobile show and had been impressed. ‘Boy, do they know how to make a car!’ was his explanation. He made it very clear that he trusted his gut feeling and was satisfied with himself and his decision. I found it remarkable that he had apparently not considered the one question that an economist would call relevant: Is Ford stock currently underpriced? Instead he had listened to his intuition: he liked the cars, he liked the company, and he liked the idea of owning the stock.”
So what does this have to do with dividends? Suppose you are trying to sell something. Bob offers you $100, and Jane offers you $200. We would be fools to accept Bob’s lower offer. Now let’s change the story a little: the asset is a company with a book value of 100; its market value is 200. If you needed cash you could sell a share for $200, but the company offers you cash of $100. Why are we so inclined in this instance to accept the $100 when we wouldn’t dream of doing so previously? Kahneman calls the preference here for the $100 a cognitive illusion and our confidence in it an illusion of validity.
We are very good at bolstering our cognitive illusions with well-honed claims: “A bird in the hand is worth two in the bush.” “I don’t trust management: if they keep it, they’ll waste it.” “Management owes me something.” We are good at this. But what does this have to do with the fact that I could have gotten a higher price? And isn’t it our job as analysts/investors to size up a company and the reliability of management before we let the two birds go in the first place?
Oh, then there is the security of a regular payment. This will insulate us from the irrational, randomness of the market, we tell ourselves. But suppose the market price of shares you own fluctuates by +/- 25%, from 150 to 250. (The Standard Deviation of the S&P 500 over the past 25 years is roughly 15%.) If you had to sell at 150 (because you waited, hoping to get a better price) wouldn’t you still net 50% more? Here the behavioral heuristic is clearly the emotion that we simply hate selling at a lower price. We have anchored ourselves to a price, not to $100, in which case we would happily accept $150, but to $200, or more likely to the high price of $250. So settling for a check for $100 avoids the pain of having to settle for $150 when we could have gotten $250. Or, adding insult to injury, the day after we accept $150 the price rises 10%.
Then there is that wonderful thing about a dividend: it just shows up in the account. I confess to regularly having the feeling that it is sort of extra. Oh, I know, the company pays an x% dividend, but it sure is nice to see it just appear in the account, like discovering I have more in my checking account than I thought. That pleasant feeling surely beats the unpleasantness of having to sell at less than the high price, or of watching the price rise after I have sold.
What is remarkable about Kahneman is that he and his late collaborator, Amos Tversky, initially observed such heuristics in their own behavior. (How moralistically superior it is if we find them only in others!) We have to work very hard to recognize the heuristics we repeatedly succumb to and try to devise means of working around them. We are ever prone to them. Even when recognized they don’t go away; they lurk; they catch us off guard. The best we can do is to rub our noses in them. Even Buffett admits that he hates buying on an uptick and cites as some of his worst errors of omission those where he stopped buying on an uptick, even though he knew the company was worth way more.
One antidote in dealing with that twinge of delight in seeing the cash appear in your account is to keep good accrual accounting. When a stock goes ex-dividend, book the dividend as a receivable; when paid, debit accounts receivable and credit cash. Programs like Quicken make improved accounting a breeze. But don’t we just love that dividend? I have yet to find anyone, however, who will answer affirmatively the question, Would Warren be richer, if Berkshire (BRK.A) had paid out 30% of its earnings in dividends for the past 45 years? Since the answer is obviously no, then we have to ask why. We would do well this Holiday Season to set as our New Year’s Resolution that we shall work fiercely in the new year to get our arms around the cognitive illusions that haunt our thinking and undermine our returns. In so doing we will come to appreciate the wisdom of Charlie Munger, “If you haven’t overturned a long-held view in the past year you haven’t been thinking.” Happy New Year!